Public Information Notice No. 06/34

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with the Islamic Republic of Iran

March 27, 2006

On March 10, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Islamic Republic of Iran.¹

Background

During the Third Five-Year Development Plan (TFYDP, 2000/01-2004/05), real GDP growth reached 5½ percent a year on average, unemployment declined, and macroeconomic indicators improved significantly, supported by favorable oil market conditions. By increasing the openness of the economy and removing major obstacles to trade and investment, the reforms introduced in the period 2000/01-2002/03 contributed significantly to this strong performance. Many challenges, however, lie ahead. The economy remains heavily dependent on oil and demographic dynamics will put increasing pressure on the labor market in the coming years. Expansionary fiscal and monetary policies have kept inflation relatively high at about 15 percent. Extensive administrative controls, widespread subsidies, and labor market regulations impose substantial efficiency costs.

On the back of favorable external conditions and an expansionary policy stance, growth resumed in 2005/06 after a temporary slowdown in the previous year. Activity has been strong, mostly in the non-hydrocarbon sector, and real GDP growth is expected to accelerate to about 6 percent in 2005/06. Unemployment, however, has continued to hover around 11 percent. Reflecting the impact of improved weather conditions on food prices, the price freeze on certain goods and services, and some exchange rate appreciation, inflation is expected to decline to 13 percent in 2005/06.

Government spending, particularly on subsidies, has continued to increase on the back of higher oil revenue, and the non-oil deficit is expected to remain high. As external developments became increasingly favorable and fiscal policy remained expansionary, the central bank allowed the exchange rate to appreciate in nominal effective terms in 2005/06. However, export growth continued apace and the current account surplus is projected to rise to 6½ percent of GDP, with international reserves reaching about $47 billion by year's end, equivalent to 9½ months of next year's imports of goods and nonfactor services. External debt remains low.

As oil-related inflows grew larger, and fiscal policy remained expansionary, the central bank increased its unsterilized purchases of foreign currency to limit the exchange rate appreciation. The monetary impact of these purchases was only partially offset by a tightening of the banks' access to the central bank credit facility, while the use of its participation papers (central bank bonds complying with Islamic finance principles) was not sufficient to mop up excess liquidity. Overall, the desired slowdown in money growth was not achieved. After having experienced rapid growth in previous years, the stock market lost about 20 percent of its value in 2005/06, reflecting uncertainty in connection with the presidential election and the negotiations on Iran's nuclear program.

Progress on structural reforms has been uneven. While financial system reform has continued, no decision has been taken on the key reform of energy subsidies, despite the increasing economic and environmental costs of the current system. The amendment of article 44 of the constitution—which delineates the domains of activity of the public sector, the cooperative sector, and the private sector—opens the door to the privatization of both financial and nonfinancial enterprises. Although this change is an important legal step, the scope and modalities of actual privatization plans are yet to be determined.

The short-term outlook is relatively favorable. Economic activity will continue to be boosted by high oil prices, although inflation could start rising again, unless the policy stimulus is reigned in. Reflecting large current account surpluses, the external debt would decline. In the medium term, however, prospects look challenging. Oil price volatility and capacity constraints in the oil sector, international tensions over the nuclear issue, and the possibility of a prolonged period of "wait and see" on the part of the private sector could adversely affect the economic outlook.

Executive Board Assessment

Executive Directors observed that real GDP growth has been robust in 2005/06 and the external position has strengthened as a result of the structural reforms implemented at the beginning of the TFYDP, favorable oil market conditions, and an expansionary policy stance. However, Directors expressed concern over the persistent high inflation that hurts the poor and fixed-income earners, the slower pace of structural reforms, and the vulnerability of the economy to a potential decline in oil prices. Directors considered that the key medium-term challenge will be to sustain high growth rates in the non-oil sector to increase employment opportunities and improve the living standard of the population. To address this challenge in an effective and sustainable way, it will be crucial to reduce inflation significantly by tightening financial policies and to accelerate the momentum for structural reforms to stimulate private sector development, lessen the dependence on the oil sector, and enhance economic efficiency, consistent with the objectives of the Fourth Five-Year Development Plan (FFYDP).

Directors noted that the substantial pro-cyclical fiscal stimulus in recent years has contributed to maintaining double-digit inflation, and underscored the need to reduce the pace of fiscal expansion and to build up precautionary savings in the Oil Stabilization Fund (OSF), consistent with the original objectives in the OSF legislation. In this context, Directors cautioned against using OSF resources to further increase government spending, as envisaged in the proposed budget for 2006/07. They recommended instead a vigorous fiscal consolidation with a reduction in government outlays in relation to GDP and implementation of revenue-enhancing measures through a broadening of the tax base and an accelerated pace of introduction of the Value Added Tax, which has been in the preparation stage for a number of years. Moreover, Directors emphasized the need for fiscal policy to be anchored within a medium-term framework to help reduce its pro-cyclicality and improve policy coordination. Directors noted with concern the size of the growing and ill-targeted subsidies, particularly on energy, which have harmful economic and environmental consequences. They welcomed the indications that the authorities plan to gradually phase out implicit energy subsidies and reduce explicit subsidies, in order to enhance economic efficiency and channel resources toward more productive uses. Accordingly, Directors urged an expeditious design and implementation of a phased program of overhauling the system, with clear time-bound reduction targets, as well as an efficient social safety net to protect the vulnerable groups.

Directors called for a tightening and a more effective use of monetary policy instruments to lower inflation to single-digit levels, consistent with the FFYDP. They welcomed the reduction in access to the central bank's overdraft facility and increased use of central bank participation papers, and encouraged a more active use of the open deposit account. While welcoming the recent steps, as well as the measures to increase the operational independence of the central bank under the FFYDP, Directors expressed concern about the new requirement of parliamentary approval for the issuance of central bank participation papers, which limits the flexibility of central bank operations in managing domestic liquidity. They noted that administrative controls on the rates of return charged on bank loans and on central bank participation papers and the continuation of directed credit hinders financial intermediation. Directors urged the authorities to remove these administrative controls and allow the rates of return to be market-determined to strengthen financial intermediation. More generally, Directors noted that a credible and successful disinflation effort will require a clearer mandate for the central bank and more effective policy instruments at its disposal. They considered that the upcoming review of the central bank law offers a good opportunity to address these issues in a decisive manner. The authorities were commended for enacting Anti-Money Laundering/Combating Financing of Terrorism legislation, and were urged to implement it expeditiously.

Directors noted that the exchange rate had been allowed to appreciate somewhat, reflecting more favorable external conditions, but, given that the fiscal stance continues to impart an expansionary impulse to the economy, they stressed the need for greater exchange rate flexibility to help contain inflationary pressures. Looking forward, Directors emphasized that the concerns on the exchange rate policy for competitiveness should be addressed by reinvigorating implementation of structural reforms and major improvements in the business climate.

Directors welcomed the progress made in establishing a risk-based supervision framework and other reforms aimed at improving the functioning of financial markets. However, they expressed concern that the continued increase in nonperforming loans and the rapid credit growth could exacerbate potential weaknesses in the financial system. Directors encouraged the authorities to further strengthen the supervision of banks, insurance companies, and securities markets. They commended the authorities for licensing additional private banks and insurance companies and encouraged them to continue opening up the banking sector to private sector participation, including through privatization, which had been made possible by the amendment to Article 44 of the constitution.

Directors underscored the importance of fostering private sector development to sustain strong growth and employment creation. They encouraged the authorities to focus on reducing the administrative and regulatory burden on private sector activities, removing barriers to competition, streamlining labor market regulations, and removing other impediments to efficiency, and accelerating the implementation of the privatization program.

Directors urged prompt action to eliminate the residual exchange restriction on the making of payments and transfers for current transactions, and welcomed the authorities' commitment in this regard.

Directors recognized the progress made in improving data quality and transparency. In particular, they were encouraged by the identification of subsidies in the central government budget. Directors stressed, however, that more work is needed to ensure an adequate and timely monitoring of public sector operations. Accordingly, they encouraged the authorities to develop a consolidated public sector balance sheet with possible technical assistance from the World Bank and the IMF. They urged the authorities to complete the requirements for full compliance with the Special Data Dissemination Standard.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.